Volatility has Spiked, Now What?

On 12/13 when the S&P 500 (^GSPC) was trading at 1430 we were focused on important contrarian signals that were giving warning signs (Read more in my article " 3 Contrarian Signals Flashing Red Alert .").

The prevailing theme of the three signals was the marketplace was complacent and ripe for a selloff, or worse, a rogue wave and a great time to buy portfolio insurance was upon us. One way to hedge your portfolio is to go long volatility.

Since mid-December the VIX (CHICAGOOPTIONS:^VIX) is up over 25% in two weeks and providing a nice windfall for the contrarians that didn't buy into the media's and wall street's rose colored glasses leading into the end of the year/fiscal cliff.

Numerous Opportunities for Cheap Protection

Throughout the last few months the VIX has hovered below 20 and even spent a majority of its time below 16. On 9/21 when the VIX was at 14, we noticed. "The VIX is at five year lows, and most other sentiment indicators are high for the market (NYSEARCA:VTI) right now, which historically marks (market) selling opportunities rather than buying opportunities".

One month later, on 10/19, the VIX was up to 15. "In the money call options with 2013 expirations could be bought as a way to hedge or to protect gains going into next year. We favor VIX options over the VIX ETPs (NYSEARCA:TVIX) as a better way to play intermediate to longer term trends in stock market volatility".

And finally two weeks ago on 12/17 inthe ETF Profit Strategy Newsletter with the VIX at 16, it was again a great time to buy protection. "The VIX has refused to spend much time below the 15 level providing a solid support and buying area for VIX bulls. As it approaches that level, buying front month in the money calls is a good trade. We like going long the VIX Jan 14 call options at $271 (OPR:VIX130116C00014000 ) per contract".

Today the VIX is at 20 and those options are up over 100%, trading for $560. Should profits now be taken?

The Charts Help

Below is the chart wehave used for the last few months that accompanied our Newsletter and Technical Forecast updates identified by the blue and red arrows. When the VIX is below 16, it is typically a good time to hedge your portfolio as the VIX bottoms and market peaks are usually just around the corner.

Right now the VIX is in a good area to start thinking about taking profits. A breakdown below key support levels such as the trendline or the 19 level, as well as a bearish indicator setup, like an RSI negative divergence, would help add evidence the VIX is taking a breather (or changing trend to down).

That RSI divergence is occurring right now and the first part of our topping puzzle is complete. Once price breaks its up trendline, profits should be taken.

If volatility is about to top, or at least stall for a bit, it would also imply the market's (NYSEARVA:IVV) selloff has bottomed and at a minimum a short-term rally (NYSEARCA:SSO) is likely to occur.

The ETF Profit Strategy Newsletter uses the VIX along with technical analysis and other sentiment measures to identify high probability trading setups for the S&P 500 and other popular asset classes. Buying in the money VIX calls has been a great high probability trade setup the last few months and will likely provide more high probability opportunities going forward.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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